Doubts settle in financial markets


Banking system : the ECB maintains its rates and injects money


Le Monde, September 8, 2007



“Behaviours we observed over the past seven weeks are identical in many respects to what we saw in 1998, to the stock market krach of 1987, to the collapse of land prices in 1837 and to the banking panic of 1907.” Former president of the american Federal reserve system (Fed), Alan Greespan, thus stressed, on the evening of Thusrday September 6, the seriousness of the financial crisis spawned by default of subprime loans (inordinately risky loans) in the United States. After several weeks of relent, tensions abruptly reappeared on financial markets.

This chaotic situation lead the European Central Bank (ECB), on Thursday, not to raise its rates, contrary to what its president, Jean-Claude Trichet, had let understand at the beginning of August. Furthermore the ECB and the Fed injected massive amounts of money into the banking system in order to avoid “its dislocation”, to use the word of Mr. Trichet. Banks were reluctant to lend money to each other, lest they do not get their funds back. This lack of trust is enhanced by the absence of precise data on exposure of financial outfits to the “subprime” risk, but also on the entire set of complex financial products. This opacity is conducive to the appearance of rumours, like that of the failure of one or several major banks.


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The crisis which unfolded this summer is lasting. Caused by the failure of a market segment a priori circumscribed and local, that of subprime mortgage loans (real estate asset backed loans with a more than normal level of risk) in the United States, it threatens the financial stability of the planet.

The market, with was flushed with liquidity, suddenly dried up. On Thursday September 6, the US secretary to the Treasury, Henry Paulson, deemed that the crisis “would take weeks, perhaps months” to heal.

“Why doesn’t anybody succeed in finding the fault? How did we get to this paradoxical situation? There is a lack of explanations”, observes Philippe Brossard, economist at Euler Hermes. Indeed, the crisis encompasses a dose of irrationality which seems self-feeding on the worries of investors.


What is the market afraid of? Investors loathe uncertainty. And since the beginning of the crisis, they navigate by sight. The world over, banks invested in securities backed by subprime loans and are likely to suffer substantial losses. But nobody knows to what extent.

Financial products created via “securitization”, where subprime loans are employed, are complex. They often mix these explosive loans with investment grade paper. In fine, the dangerous products become almost invisible. Moreover, the financial accounting procedures often enable banks not to record these securities into their balance sheets [the intermediate banks who “securitized”, i.e. bundled, the mortgage loans they had extended to risky private individuals, and then sold to other investors, often hedge funds ; but sometimes these banks retain a partial liability if the loans default – despite the intricate financial circuits and transfers of property and therefore liabilities, it boils down to risky loans to bad debtors, and then the entities which made the loans are exposed, and when they are large banks, the creditors of these large banks, common households and firms, are exposed as well, whence possible series of financial failures like falling rows of dominos. The contemporary medicine, as opposed to that of the early Thirties, is to inject money into the system to ease credit and prevent failure, but nobody really knows the potentially adverse consequences of this temporary injection of money.]. “It is impossible to evaluate losses. The market discovers them one after the other but does not see the end of the tunnel”, says René Desfossez, strategist at Natixis. Meanwhile, “financial people are staring at each other [to try and see who is exposed]”, admits a trader.

Noxious rumours swell. Banks which borrow are suspected to do it to wipe out subprime losses. Ten days ago Deutsche Bank thus launched a ten year bond issue. On the 31st of August, the market feared possible difficulties of Barclays which had borrowed 1.6 billion pounds (2.36 billion euros) from the Bank of England. On Wednesday, investors were concerned about the overexposure of Citigroup, the first bank in the world in terms of stock market capitalisation.

This climate of distrust has an impact on the inter bank market where banks borrow and loan each other money. The risk premium currently asked for is unusually high. In Europe, some large banks a priori in good financial health “borrow long term money [i.e. issue long term bonds] accepting to pay the same rate as emerging countries”, says a befuddled trader.

Alan Greenspan, the former president of the US Federal reserve board (Fed), evoked last Thursday similarities between the present crisis and that of 1998 (following the collapse of the hedge fund LTCM) and the stock market krach of 1987. The “old wise man” even draws a parallel with the crisis caused by the collapse of land prices in 1837 and the banking panic of 1907!


Are banks threatened by failure? The German banks IKB and Sachsen LB illustrated the seriousness of the crisis. They went to the brink of failure because of their investments in the United States. The German regulatory body, the BaFin, thought then that the country was “threatened by the worst financial crisis since 1931”.

Nonetheless, few analysts imagine that the world banking system could be under threat. “The risks are probably overestimated”, deems Cyril Regnat of Natixis. Large banks have accumulated enough profits over the past years to be able to weather possible losses.

Yet, “the figures one hears of are frightening”, admits one trader. On Tuesday, a memo from Barclays mentioned 1400 billion dollars (1023 billion euros) worth of financial products which banks might have to refinance. And as the crisis intensifies, this figure rises.


Can central banks solve the crisis? Monetary authorities can only “alleviate” the banking system difficulties by offering temporary credit facilities. Most central banks have “injected” money regularly since the beginning of August, to the tune of dozens of billions of euros in the monetary circuits. But these actions are only temporary expedients. The sums poured into the system are in fact special loans extended to banks, overnight, for a week, or for three months. And banks already have refunded or will have to refund these credits. To enhance its impact, the Fed, on the 17th of August, lowered one of its refinancing rates to banks. To no avail.

Following the president of the Deutsche Bank, Joseph Ackermann, Jean-Claude Trichet, the president of the European Central Banque, declared on Thursday that “the principal ingredient missing is confidence”. Current worries are “due for a large part to the lack of sufficient transparency on the risks incurred” by the banks, he added.


Is the economy in jeopardy? On Thursday, the International Monetary Fund (IMF) announced that it was revising its forecasts for growth in 2008, lowering them to take into account the impact of the financial crisis. Until now they were 2.8% for the United States and 2.5% for the Euro zone.

The situation of the American economy, which was already slowing down, is penalised. According the Mortgage Banks Association (MBA), the number of homes seized back by banks [because the dwellers, indebted to the banks, defaulted seriously on their payment schedule] reached a record level during the second quarter in the United States, and more than 5% of American households have experienced delays in their repayments. Moreover, 35 000 jobs were cancelled in the financial sector in August. The Lehman Brothers bank just announced 850 lay-offs.

The subprime crisis is degenerating into a generalised credit crisis (credit crunch). From firms which have difficulties financing themselves, to real estate loans and credits to consumption which may become more expensive, it is the whole system which is under duress.


Claire Gatinois and Cécile Prudhomme


Translation André Cabannes